Set money market and capital market instruments side by side and weigh their strengths and weaknesses.
The idea
Money market instruments are debt securities with an original maturity of one year or less, such as Treasury bills, commercial paper, negotiable certificates of deposit, repurchase agreements and bankers' acceptances. Capital market instruments have longer maturities: Treasury notes and bonds, agency and municipal bonds, corporate bonds and mortgage-backed securities. The money market offers liquidity, small price swings (duration is below one) and predictable cash at maturity. Its drawbacks are lower yields and reinvestment risk when rates fall. The capital market pays more through term premium and credit spread. Its price change is roughly minus duration times the yield change, so a rate rise can create large losses, and resale markets are thinner. Discount instruments such as bills are quoted on a 360-day discount basis. Convert to a bond-equivalent yield before comparing. Exams test this liquidity versus yield trade-off.
Formulas
Price change estimated from modified duration
%Δprice ≈ −ModDur × Δyield
- %Δprice
- the percentage change in the bond's full price
- ModDur
- modified duration
- Δyield
- the change in yield, as a decimal - 25 bps is 0.0025
Money market instruments have durations below one, so the same yield rise costs far less than on a long note. Treating 50 basis points as 0.05% rather than 0.50% is the usual slip.
Bond-equivalent yield of a Treasury bill
BEY = (100 − P) ÷ P × 365 ÷ n
- P
- the bill's price per 100 of face
- n
- the actual days to maturity
P comes from the discount quote, 100 − discount yield × n ÷ 360. The discount yield understates the return because it uses face value and 360 days.
A practice question
Which statement best describes the trade-off between money market and capital market instruments for a bank?
- Money market instruments carry more price risk than capital market instruments but pay a lower yield.Why not: Reverses the price-risk relationship: short maturities mean low duration and small price changes.
- Capital market instruments are more liquid because their longer maturities attract more dealers.Why not: Longer maturity does not mean more liquidity; the money market is the more liquid, low price risk end.
- Money market and capital market instruments differ only in credit quality, not in liquidity or yield.Why not: Maturity, not credit quality, defines the two markets, and it drives differences in liquidity, price risk and yield.
- Money market instruments offer high liquidity and little price volatility but lower yields; capital market instruments pay more but carry greater price risk. - correct
Short maturities give high liquidity, low duration and predictable cash, at lower yield and with reinvestment risk. Longer capital market securities compensate with a higher yield but larger price swings when rates move.
A harder one
A bank holds USD 20 million of 3-month Treasury bills (modified duration 0.25) and USD 20 million of 10-year Treasury notes (modified duration 8.0). Yields on both rise by 50 basis points. Using duration only, how much more does the note position lose than the bill position?
- USD 775,000 - correct
- USD 800,000Why not: This is the loss on the note position alone; the bill loss of USD 25,000 is not subtracted.
- USD 825,000Why not: Adds the two losses (800,000 + 25,000) instead of taking the difference.
- USD 77,500Why not: Treats 50 basis points as 0.05% rather than 0.50%, a factor of ten too small.
Note loss = 20,000,000 x 8.0 x 0.005 = 800,000. Bill loss = 20,000,000 x 0.25 x 0.005 = 25,000. Difference = 775,000, showing how much more price risk the longer instrument carries.
The hardest tier
A 91-day Treasury bill is quoted at a discount yield of 4.80% (360-day basis). Price per 100 of face = 100 - 4.80 x 91/360. Using a 365-day year, the bond-equivalent yield (return on price, simple annualized) is closest to:
- 4.80%Why not: Reports the quoted discount yield; the discount is measured on face value and 360 days, not on price and 365 days.
- 4.86%Why not: Annualizes the return on price using 360 days (money market yield) instead of the 365 days used for bond-equivalent yield.
- 5.02%Why not: Compounds the 91-day return to an effective annual rate; bond-equivalent yield is a simple annualized figure.
- 4.93% - correct
Price = 100 - 4.80 x 91/360 = 98.7867. Holding return = 1.2133/98.7867 = 1.2282%. Bond-equivalent yield = 1.2282% x 365/91 = 4.93%. Discount yield understates the true return because it divides by face value, not price.
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